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The Phantom of the Megaplex

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In a drama that has moved from the silver screen to real life, four major movie-theater chains have rushed for protection under Chapter 11 of the U.S. Bankruptcy Code in recent months. The filings may be just the beginning for the troubled theater-chain business, analysts say.

The problem is simple: There are just too many movie theaters in America, as any regular visitor to one of the 24-screen "megaplexes" can attest. But other factors — most notably a leaseholder-friendly provision that exhibitors have discovered within the Bankruptcy Code itself — are helping to determine the legal course that the theater chains have chosen.

The cast of characters includes Carmike Cinemas Inc., General Cinema Theaters, and the privately held United Artists Theatre Co. (UA) and Edwards Theatres Circuit Inc. — all of which are seeking Chapter 11 relief. Other large outfits, such as Regal Cinemas Inc. and Loews Cineplex Entertainment Corp., may soon join them. In the standard theater-operating model, these exhibitor chains generally selected sites and then constructed the theaters. The facilities were then sold to real estate investment trusts or other corporate landlords, and leased back by the exhibitors.

More than 350 theaters, comprising 1,888 screens, have been closed since last January. The closures represented 5 percent of America's theaters and 5 percent of its 36,448 screens. Analysts figure that is still perhaps 5,000 to 7,000 too many. The exhibitors' bankruptcy proceedings, which in some cases are also now tying up the landlords, could result in more closures.

"There really was no choice; we were plain out of liquidity," says David Giesler, executive vice president and CFO of Denver-based UA, a 215-outlet chain that recorded $631 million in 1999 revenues, along with a net loss of $127 million. "This industry would have to grow its business as much as 50 percent to meet our added costs per screen, which is next to impossible," he adds.

The exhibitors, though, have found something of a silver lining in the dark cloud of Chapter 11 bankruptcy proceedings, which have pummeled shareholders and given holders of existing debt less than 100 cents on their dollars. That saving grace is the Bankruptcy Code's Section 502(b) (6), which in effect allows exhibitors to stop paying rent to landlords of vacated movie houses by setting a formula for sharply limiting damages to the movie-house chains when leases are rejected.

"Given the ability to reject leases under Chapter 11, we can create a new, clean company," says Giesler. Section 502(b)(6) is designed so that leases on the poorest properties are eliminated, and "you end up with a portfolio that is theoretically all winners, no losers. So you don't have to absorb the cash-flow losses of an underperformer with the positive cash-flow winnings of a good theater." Even if current shareholders are unhappy, says Giesler, "the cleanup process makes the company attractive to new equity."

Megaplexes Multiply

The current sorry state of the theater-chain business had its origins in the late 1970s, when the industry began dividing older cinemas into two-screen venues and fourplexes. With multiple screens, "a theater could have common facilities like concession stands and rest rooms, share ticket-takers and concession attendants, and minimize empty seats by varying the size of the auditoriums," explains Andrew Lipman, head of distress debt research at New York­based investment bank ING Barings LLC.

When the technique proved popular and profitable, exhibitors built even more multiplexes, usually in malls, with 8 to 12 screens. Then, in 1994, Kansas City­based AMC Entertainment Inc. doubled the stakes by building the world's first megaplex, a 24-auditorium stadium-seat behemoth between Dallas and Fort Worth. Loaded with design extras like coffee bars and video arcades, "it changed the way people looked at theaters," says Giesler, and it ignited a building boom. "We opened 35 megaplexes and retrofit 24 from early 1998 through September 2000, each with 10 to 20 screens and all-stadium seating," says Martin Durant, senior vice president and CFO of Carmike Cinemas, in Columbus, Georgia.

It proved to be too much of a good thing. The public tended "to abandon the old multiplexes," acknowledges Durant. "Suddenly, we had all this brick and mortar no longer generating positive cash flow. Yet the cost of running these theaters continued."

Greenbacks in Hollywood

Like the Sorcerer's Apprentice, movie-house chains kept building new theaters, even while exhibitors negotiated with landlords to get out from under their old lease burdens. The more stunning growth, though, was in new screens. In 1990, there were only 22,904 separate screens. But by the end of 1999, the screen count had surged nearly 60 percent, and was approaching 40,000.

Theater attendance, meanwhile, continued to grow at only a snail's pace: "an average of 1 percent to 3 percent per year," according to David Farber, CFO of Urban Data Solutions Inc., a privately held New York­based software and data management company, and former CFO of Magic Cinemas, an exhibitor acquired by Regal Cinemas in 1997. Ticket prices increased just as slowly: only 2.5 percent annually over the past decade, estimates ING Barings's Lipman.

On the cost side of the equation, megaplexes require much heavier outlays. The higher ceilings required for stadium seating cost theater chains roughly $100,000 more per screen, and then there are all the other costs — coffee bars, game rooms, and so on. "Basically, the industry was building more seats, at greater cost, while attendance remained flat and ticket revenues were stagnant," adds Farber. "It doesn't take a genius to see where the industry was headed."

The biggest mystery is how these disturbing metrics failed to dissuade big investors and lenders from taking a flier on the industry. Buyout firms like Kohlberg Kravis Roberts & Co. (KKR), of New York, and Hicks Muse Tate & Furst Inc., of Dallas, "saw greenbacks in the hills of Hollywood, and plunked down millions" to buy Regal Cinemas in 1998, says Farber. "Wall Street threw money at the exhibitors," adds Lipman.

When it came to borrowing for the expansions, says Carmike CFO Durant, "money was offered cheap. The bond market was floating bonds in the neighborhood of 9 percent, a terrific rate for long-term money. The lure was overwhelming. We figured if we didn't start building these megaplexes, someone else would."

Farber agrees. "Lenders made it so exhibitors could leverage the hell out of the build at very low financing cost," he says. "Some companies were financing significant amounts of the build, figuring 'We'll build them; they'll come.'" And they did, only "just to the megaplexes."

In that environment, Regal ran up capital expenditures of $1.25 billion between 1997 and 1999; Plano, Texas-based Cinemark chalked up $884 million; AMC spent roughly $800 million; and Carmike spent $425 million. "Then Hollywood came along with a horrible year's worth of movies," says Farber. "And now the exhibitors are drowning in debt." Box office grosses rose 0.2 percent through the first 11 months of 2000, according to ACNielsen Co. The reaction among many exhibitors was to close theaters.

Gail Edwards, president and CFO of GC Cos., General Cinema's parent, which had 1999 revenues of $386 million and a loss of $2.3 million, says the megaplex phenomenon sapped 15 to 40 percent of its patronage at older multiplexes, depending on the market. "Imagine losing 40 percent of your patrons from what was formerly a profitable and cash-flow-positive theater," says Edwards. "It damages the rest of the business."

Chapter 11 to the Rescue

Soon, exhibitors noticed the inviting provisions of the Bankruptcy Code's Section 502(b)(6) within Chapter 11, and began to move in that direction. "The code offers debtors favorable opportunities for lease rejection," says Sanjay Nayar, an ING Barings vice president. Indeed, the formula limits landlords to general unsecured damage claims in the amount of one year's rent or 15 percent of the remaining lease term (not to exceed three years), whichever is greater.

And that isn't the only advantage for exhibitors. "Even if the formula caps the damages at, say, $5 million, that doesn't mean the landlord will get paid 100 cents on the dollar," notes Nayar. "In UA's case, for example, general unsecured claims are getting paid a small fraction of par." Further, if a landlord is able to rent or sell the building, the amount received reduces the total to be paid by exhibitors under Section 502(b)(6), making the theater-chain industry's landing under bankruptcy even softer.

Regal Cinemas, too, has announced that it is considering a bankruptcy court filing or other financial restructuring. The company is in technical default on certain financial covenants. Regal backers KKR and Hicks Muse now are reported to have a paper loss of some $500 million each on their investments, given Regal's debt load of some $2 billion.

How have the landlords and other creditors reacted to all this favorable treatment for the exhibitors? Four major law firms representing landlords and other unsecured creditors in the various bankruptcy proceedings declined comment for this article. However, Russ Munsch, a partner in the Dallas-based law firm Munsch, Hardt, Kopf & Haar, which represents BNP Paribas, a Paris-based bank that is a lender to Edwards Theatres, says he has concerns that Chapter 11 protection may not provide all of the benefits that the theater owners are looking for.

"Chapter 11 is not a panacea," says Munsch. "Even with Section 502(b)(6), there can still be a substantial amount of unsecured debt generated from the rejection of the leases," he explains. "That debt has to be repaid before the equity holders, in this case the Edwards family, can receive or retain anything under the [restructuring] plan." Edwards Theatres declined to comment on the remarks.

There may be one fly in the ointment for exhibitors: a question of good faith. Gerald K. Smith, chair of the Chapter 11 subcommittee of the American Bar Association, postulates that courts may not look favorably on exhibitors that cannibalized their older theaters to improve the performance of new megaplexes in the same market. "If it can be shown," says Smith, a partner in the Phoenix-based law firm Lewis and Roca, "perhaps through corporate records, that these companies abandoned their older facilities to put up new facilities, with the goal of getting out from under their long-term leases someday through Chapter 11, I doubt the courts would stand for [it]." ING Barings's Lipman, however, believes the likelihood of theaters being hurt on bad-faith grounds is slim. "I wouldn't want to go to court with that argument," he says.

Who is at fault, then? "Everyone screwed up," concludes Oren Cohen, a high-yield media analyst at Merrill Lynch in New York. "You've got to point the finger from Wall Street to the exhibitors," whose building was "so frenzied by the profit motivation they became irrational." Meanwhile, "the capital markets and bankers kept throwing fuel on the fire. I still can't believe KKR and Hicks Muse paid 15 times trailing cash flow to buy Regal, a company in a mature industry," he says.

The lesson he draws: "When money is cheap, everybody has their hands out." Strategically, companies are focused only on themselves, "and assuming the market will accommodate everyone. Then, when the fog lifts, they look around and see the whole industry has done the same thing. In this case, they're all awash in theaters and screens."

"If this were a movie," he says, "I'd call it A Formula for Disaster."

Russ Banham is a contributing editor of CFO.

The Last Picture Show

An excess of silver screens led these movie-house chains into the red — and bankruptcy court.Source: National Association of Theatre Owners